Emerging derivatives markets?

1 BIS Quarterly Review, December 2016 67 Christian Emerging derivatives markets? 1 Only 10% of global derivatives turnover is in contracts denominated in the currency of an Emerging market economy (EME), much lower than the share of these economies in global GDP or world trade. derivatives in EME currencies also tend to be less complex and more likely to be traded outside the home economy than those in advanced economy currencies. Differences persist even if we control for key drivers of derivatives turnover such as the size of the bond market, the openness of the capital account, the amount of foreign trade and the size of external liabilities.

2 Instead, the small size of EME derivatives markets appears to reflect differences in per capita income. Large external asset holdings by residents of a country go hand in hand with lower turnover, perhaps because they are used as a hedge against country risk. JEL classification: F31, G12, G23. The economies and financial markets of Emerging market economies (EMEs) tend (with some exceptions) to be more volatile than those of advanced economies. This is true whether one looks at output growth, exchange rates, interest rates or capital flows.

3 Given this volatility, one would expect hedging markets in EMEs to be well developed. But this does not seem to be the case. EMEs make up about one third of the global economy when measured at market exchange rates and just under one half when measured at purchasing power parity. Their share in global trade is 36%. Still, derivatives referencing their currencies or interest rates account for only 10% of the global turnover of such contracts, despite notable growth in some cases in recent years. But the desire to hedge need not result in liquid markets unless there is somebody willing to take the other side.

4 For idiosyncratic risks that are easily diversifiable, a financial intermediary could sell the appropriate insurance. But creating a market for macroeconomic risks, such as exchange rate and interest rate risk, is much more difficult unless there are agents who are exposed to such risk in opposite ways. Consider the example of an EME with a volatile exchange rate. Residents and foreign investors alike will probably be interested in protecting themselves against a depreciation in the exchange rate, but it is less obvious who would be willing to take the other side.

5 Of course, foreign financial institutions with no particular interest in gaining exposure to the currency could offer such protection, but they would 1 The views expressed here are those of the authors and do not necessarily reflect those of the BIS. We are grateful to Claudio Borio, Ben Cohen, Ramon Moreno, Hyun Song Shin and Phil Wooldridge for helpful comments and suggestions. Diego Urbina provided excellent research support; we are grateful for his patience and dedication. The authors of Box A would like to acknowledge the help of Steven Kong, Jimmy Shek, Tsvetana Spasova and Agne Subelyte.

6 See the Glossary (BIS (2016)) for definitions of relevant technical terms . 68 BIS Quarterly Review, December 2016 probably charge a very high price. More attractive terms could be obtained from market participants wanting to protect themselves against an appreciation for instance, domestic holders of foreign assets or foreigners issuing domestic currency debt. This article uses the latest vintage of the BIS Triennial Central Bank Survey to examine how derivatives trading on EME exchange rates and interest rates has evolved and why it remains lower than for advanced economies.

7 Our focus is on the ability to trade EME risks rather than on trading derivatives locally, so we focus on derivatives on EME currencies and interest rates (including those traded offshore) and not just on contracts traded domestically in EMEs. Given the focus of the Triennial Survey, we limit ourselves to exchange rate and interest rate contracts and do not discuss other risk categories such as equities and commodities, despite their importance for both EME residents and foreign investors. The article is divided into two parts.

8 In the first part, we compare derivatives markets in EMEs with those in the advanced economies using data from the Triennial Survey. In the second part, we look at the factors that explain cross-country differences in the development of these markets. derivatives markets in Emerging and advanced economies The sharp movements in exchange rates during the past few years masked a solid increase in activity in EME derivatives . Average daily turnover in FX and interest rate derivatives denominated in EME currencies stood at $ trillion in April 2016, almost Growing underlying activity offset by exchange rate movements Average daily turnover in April, net-net basis;1 in billions of US dollars Graph 1 1 Over-the-counter (excluding spot transactions) and exchange-traded derivatives .

9 Sources: Euromoney TRADEDATA; Futures Industry Association; The Options Clearing Corporation; BIS derivatives statistics and TriennialCentral Bank Survey. 050100150200 CNYBRLKRWMXNTRYINRZARRUBPLN2013At current exchange rates:20160481216 HUFMYRTHBCZKCLPILSSARIDRCOPPHPPENARS2013 , at constant exchange rates BIS Quarterly Review, December 2016 69 the same as in April 2013, on the cusp of the bout of sharp market moves that started a month later (the so-called taper tantrum).2 But this apparent stagnation paints a 2 Includes all contracts in the Argentine peso (ARS), Bulgarian lev (BGN), Bahraini dinar (BHD), Brazilian real (BRL), Chilean peso (CLP), Chinese renminbi (CNY), Colombian peso (COP), Czech koruna (CZK), Hungarian forint (HUF), Indonesian rupiah (IDR), Israeli new shekel (ILS), Indian rupee (INR), Korean EMEs have smaller markets Average daily turnover in April 2016, net-net basis.

10 1 in per cent Graph 2 Total turnover relative to GDP FX derivatives turnover relative to trade2 Total turnover relative to gross international external assets and liabilities3 1 Over-the-counter (excluding spot transactions) and exchange-traded derivatives . 2 Exports plus imports of goods and services. 3 Assets exclude reserve assets. Sources: IMF, Balance of Payments Statistics and World Economic Outlook; Euromoney TRADEDATA; Futures Industry Association; The Options Clearing Corporation; BIS derivatives statistics and Triennial Central Bank Survey.